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Error.

The subject of "tracking error" is one of the wonkier corners of ETF investing, which is itself, let's be honest, a fairly wonky subject to start with. But anything that costs investors money is worth paying attention to -- especially when it's fairly easy to avoid.

Most ETFs are designed to track the performance of an underlying index of assets. Tracking error is the degree to which an ETF fails to do so. Put another way, tracking error is the difference -- positive or negative -- in total return between an ETF and its benchmark. Joel Dickson, head of Vanguard's active quantitative equity group, warns that while the subject gets complicated fast, the main reason for investors to be aware of tracking error is that it "can indicate the quality of the portfolio-management process." Some research firms, such as Morningstar and XTF, have tools on their Websites that reveal tracking error.

For most U.S.-listed ETFs, the amount of tracking error is small and has been falling. According to a recent analysis by Morgan Stanley Smith Barney, tracking error for all U.S.-listed ETFs averaged 52 basis points (or slightly more than half of one percent) in 2011, a decline of 73 basis points since 2009. Improvements in process and technology were big contributors to the decline, the study said, as well as better indexing techniques and increased access to global markets.

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Tracking error tends to vary based on the size and liquidity of the underlying index, which makes it difficult to put a number on how much is too much, says Michael Johnston, analyst and co-founder of ETF Database. The bigger and more liquid the index, though, the easier it is to track accurately. "For an ETF based on the S&P 500," Johnston says, "anything above 10 basis points [of tracking error] would be a red flag for me."

ETFs based on more illiquid indexes, however, often have more tracking error. Commodity ETFs often have significant tracking error because they depend on futures and derivatives contracts to replicate an index (it's cheaper to buy natural gas futures than to buy and store natural gas), and the price of those instruments may be out of sync with the spot price of the physical asset. (Which, according to some, isn't really a tracking error, though investors need to understand the divergence.) International ETFs experience tracking error when U.S. markets are closed but foreign markets are open. While these examples could mean a tracking error of up to 100 basis points, Johnston says, anything more could indicate a problem.

Even so, we're talking about small numbers here, which is why some investors choose to stick with the biggest and best ETFs and not worry about whatever minor deviations they have from the index. Count Rick Ferri, founder of Troy, Mich.-based Portfolio Solutions among them. "We don't have an issue with tracking error," he says. Aniket Ullal, founder of First Bridge Data, agrees, "For U.S. indices, it's a non-issue." As for the greater tracking error inherent in ETFs based on less-liquid indexes, generally "the problem isn't the ETF. It's the index," Ferri says.

Whether or not you choose to obsess over every last basis point, the four main drivers of tracking error are important to keep in mind when choosing an ETF.

Fees and expenses: This is the most common and, for most ETFs, the largest source of tracking error. Because fees are deducted from an ETF's total return, a perfectly designed ETF will always generate a smaller total return than an index, which is a hypothetical market construct with no managers and no trading costs. In other words, an ETF that tracks its index perfectly will still have a tracking error equal to its expense ratio.

Optimization: Most ETFs based on a large, liquid indexes, like
State Street's SPDR S&P 500spy 0.2975793915167666%SPDR S&P 500 ETF TrustU.S.: NYSE Arca225.82
0.670.2975793915167666%
/Date(1481302531926-0600)/
Volume (Delayed 15m)
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1.9152069736056108% Rev. per Employee
N/AMore quote details and news »spyinYour ValueYour ChangeShort position
(SPY), actually own every asset in the index. Acquiring all the components in the indexes of less liquid assets, such as fixed income, developing markets, or commodities, can present a challenge. To match the performance of those indexes at reasonable cost, many ETF managers use "optimization" techniques, identifying and buying a smaller set of assets that represent the target index, matching sector weighting, credit worthiness and other factors. For instance,
SPDR Nuveen Barclays Capital Short Term Municipal Bond ETFshm -0.09380863039399624%SPDR Nuveen Bloomberg Barclays Short Term Municipal Bond ETFU.S.: NYSE Arca47.925
-0.045-0.09380863039399624%
/Date(1481302481955-0600)/
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95528
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N/AMore quote details and news »shminYour ValueYour ChangeShort position
(SHM) held only 373 of the 3,701 securities in the index it was designed to replicate yet, last year, not counting fees, had tracking error of just nine basis points.

There may be more than meets the eye when comparing an ETF's return to that of the underlying index.
Peter and Maria Hoey for Barron's

Index changes: Indexes change, adding or dropping components, and they do so without incurring any trading costs. As ETFs adjust their holdings to match the index, the cost of that buying and selling will eat away at returns and contribute to tracking error.

Diversification requirements: ETFs are subject to the same rules governing mutual funds, which include strict diversification requirements. No more than 25% of total assets can be in a single security, and securities with more than a 5% share cannot exceed 50% of the fund. To meet those limits, ETF managers may employ optimization strategies that can introduce tracking error. For true index investors, this gets dangerously close to active management. Whether or not the index optimization works in your favor or costs you money is entirely dependent on the prowess and luck of the people doing the optimizing. The
iShares MSCI Spain Index fundewp -0.44726052925829296%iShares MSCI Spain Capped ETFU.S.: NYSE Arca26.71
-0.12-0.44726052925829296%
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4.124214071856287% Rev. per Employee
N/AMore quote details and news »ewpinYour ValueYour ChangeShort position
(EWP) outperformed its target index in 2011 by 223 basis points, partly because the ETF invested less in some stocks.

Keeping tracking error to a tolerable level is not difficult. Simply to look for ETFs with the lowest expense ratios, and don't require frequent re-balancing.